Fear Higher Taxes? Then Buy These Tax-Free High Yielders

So when the largest fund manager in the world, with assets under management approaching $1 trillion, began aggressively buying and recommending municipal bonds to avoid potential tax increases due to the fiscal cliff, the Street took note. Like Treasuries, municipals bonds or "munis" are issued by the government. But instead of coming from the federal government, these bonds are issued by local municipalities like cities, counties and public utility districts.

Gross' interest in municipal bonds is because of their special tax handling. Unlike Treasury and corporate bonds, municipal bond holders are exempt from paying federal income tax on interest income. Some municipal bonds are tax-exempt on the state level as well. This can translate into big tax savings, particularly for earners in higher tax brackets.

TakeSPDR Nuveen Barclays Capital Muni Bond (NYSE: TFI) for example, which is an exchange-traded fund (ETF) that tracks the performance of the Barclays Municipal Managed Money Index. This municipal bondETF's stated yield is almost 3%, which is an already respectable return in a low-yield environment. But for someone with taxable income of $250,000, falling into the 39% federal tax bracket that's supposed to kick in on Jan. 1, 2013, avoiding taxes on this extra stream of income lifts the effective yield of the TFI to about 4.3%. And that's not including exemptions on the state level, which potentially push yields above 5%.

That's almost three times the return of the benchmark 10-year Treasury note and better than most investment-grade corporate bond ETFs such as iShares iBoxx Investment Grade Corporate Bond (NYSE: LQD), which yields almost 4% and the iShares Barclays Credit Bond (NYSE: CFT), which yields 3.5%. But these investment-grade corporate bonds are not tax-exempt, so when you add in taxes from either income or capital gains, then the advantages of municipal bonds are even more pronounced. Those tax savings have driven big capital inflows into municipal bonds in the past three months. The chart below shows the TFI recently hitting a new all-time high.

Big institutional investors like Gross are fueling this bullish movement, but retirees searching for income are also driving the trend. Munis are a great way for retirees to invest in relatively stable and secure assets while picking up an outsized, tax-exempt yield. These are the kind of assets we here at Street Authority call"Retirement Savings Stocks."

Although there is slim chance municipal bonds could lose their special tax treatment in negotiations related to the fiscal cliff, as it stands, there are not too many other places for investors to find tax shelter and a great yield.

Here are three of my favorite municipal bond ETFs.

1. iShares S&P National AMT-Free Muni Bond (NYSE: MUB)This is the highest volume and most liquid municipal bond ETF in the market, with average daily volume of 248,000 and about $3.5 billion in assets under management. The MUB corresponds to the performance of the S&P National AMT-Free Municipal Bond Index, an index of investment-grade municipal bonds. With a stated yield of almost 3%, high earners can easily reach into a 4% effective yield with special tax treatment on income. With an expense ratio of 0.25%, slightly below the category average of 0.28%, this muni bond ETF is also a great bargain right now.

2. Market Vectors High-Yield Muni ETF (NYSE: HYD)This is also a municipal bond index fund, seeking to replicate price and yield of the Barclays Capital Municipal Custom High-Yield Composite Index. With high-yield carrying exposure to lower credit grades, this ETF has an outsized stated yield of nearly 5%, the highest of the group. This has attracted plenty of interest from investors seeking protection from the tax man, with average daily volume of 275,000 and a little more than $1 billion in assets under management. And with an expense ratio of 0.35% also below its category average of 0.40%, this municipal bond ETF is another great Retirement Savings Stock.

3. Market Vectors Long Municipal Index ETF (NYSE: MLN)
This municipal bond ETF corresponds to the price and yield of the Barclay Capital AMT-Free Long Continuous Municipal index. With exposure to longer-dated maturities, this ETF is a little more volatile than most municipal bonds and bond funds. But investors are compensated for that extra risk, rewarded with a stated yield of almost 4% that once again beats Treasuries and investment-grade corporate bonds. This is a relatively small municipal bond fund, with average daily volume of 40,000 sharply lower than the previous two ETFs, but still providing plenty of liquidity for most investors. Assets under management are $120 million, and with an expense ratio of 0.24% below the category average of 0.28%, this ETF is another great way to cut fees and reduce taxes.

Risks to Consider: Muni bonds are not totally immune to fiscal issues. Many municipalities are battling financial problems of their own, which could potentially weight on asset values and capital gains in the long run. Although it is highly unlikely, new fiscal cliff legislation could compromise the tax benefits of municipal bonds as politicians look for more revenue to fund an outsized deficit.

Action to Take --> Municipal bonds have always been great tax shelters, especially for high earners and retirees. But with the fiscal cliff creating uncertainty over taxes, there have been big capital inflows into the group in the past few months. In spite of those gains, municipal bonds are still one of the few assets that offer tax-exempt income. And with the fiscal cliff approaching, investors looking to reduce their tax liability can only benefit from the tax-free yields of the muni bonds.